The US Securities and Exchange Commission’s decision to ask Congress to increase its fiscal 2023 budget to more closely monitor the cryptoasset market has resurrected the issue of whether members of one asset class should subsidize oversight of another, but there is no change in sight.
The regulatory agency’s crypto-related enforcement actions have soared over the past year and the SEC wants to step up its enforcement team to investigate violations in securities law related to crypto asset offerings, exchanges, lending products and DeFi platforms. Security Traders Association (STA), the financial services trade group which includes traders at buy and sell-side firms, says that cryptomarket traders and investors should pay for the SEC’s higher budget. Cryptoasset experts counter that the current funding model is legit, and it is impractical to implement a new method for funding the SEC.
Retail interest in cryptocurrencies has always been strong, while institutional interest in cryptocurrencies and other digital assets started increasing since 2020 due to the economic effects of the Covid-19 pandemic. The narrative for Bitcoin, the most popular cryptocurrency, is that it is a safe hedge against inflation — a “digital gold”– and the 2021 crypto bull run saw BTC hit record highs in April and November. Since then Bitcoin has lost more than half its value to reach below $30,000 on July 20, 2022.
In May, SEC Chairman Gary Gensler asked the House Committee on Appropriations for more than US$2.1 billion for the fiscal year 2023 budget because of the highly volatile and speculative nature of the cryptomarket. “The additional staff will provide the [Enforcement] Division with more capacity to investigate misconduct and accelerate enforcement action,” said Gensler noting that the SEC had taken close to 90 enforcement actions against digital asset firms since 2017 garnering US$2 billion in penalties. The US$2.1 billion is about US$240 billion more than the SEC asked for in FY 2022. Any money the SEC garners from enforcement action goes to the US Treasury, rather than the SEC.
Congress is tasked with approving or denying the SEC’s annual budget request and so far, it has not made any decisions about FY 2023 budget. The money allotted does not come from the Treasury or settlement of enforcement action. Instead, the funds come exclusively from transaction fees in equity trades. Agency broker-dealers are allowed to transfer these fees to their customers each time they buy and sell securities. Principal trading firms must pay the transaction fee themselves. Both types of broker-dealers forward these fees to exchanges, self-regulatory organizations, which in turn send them to the SEC.
The Dodd-Frank Act of 2010 included amendments to the Exchange Act of 1933, which set up a process to calculate and alter transaction fee rates. “After the SEC’s annual budget is approved, the fee per transaction is determined by the SEC based on its estimate of funding volume for the fiscal year and can be altered six months into the year if the SEC is tracking to either under-collect or over-collect the amount of approved annual budget,” says Jim Toes, president and chief executive of STA. In 2021 and the first half of 2022 the fee was US$S.10 for US$1 million in notional value of equities traded. With trading volumes sagging this year, the rate has increased to US$22.90 for US$1 million in notional value of equities traded.
“Changing the SEC’s funding model requires an act of Congress,” says Toes. “Regulators and lawmakers need to work together to find a way for the cryptomarket to pay for its regulation through a legislative act.” STA’s position parallels an argument the group made back in 2012 concerning the oversight of the fixed-income market. At that time, Toes suggested that fixed-income transactions be charged a transaction fee to pay for the SEC’s oversight of the corporate bond market. However, that argument did not lead to reform. “The majority of broker-dealers who would have been assessed the fee on fixed-income transactions were the same firms executing equity transactions, so they didn’t see the need to change the process as they already fell under the SEC’s jurisdiction.” says Toes.
That is not so in the cryptomarket, which is why Toes is confident his organization stands a greater chance of success. Traders who execute equity orders on a principal basis must pay the transaction fee out of their own pockets and are more likely to balk at subsidizing cryptomarket oversight because they may not be heavily involved in the cryptomarket. Those principal trading firms, which Toes declined to name, are also telling Congress that the SEC needs to ask the cryptoindustry for funding. Among the largest principal trading firms for equities are Goldman Sachs. JP Morgan and Citi.
The debate over who should pay for the SEC’s oversight of the cryptoindustry is unlikely to be squashed by a new bipartisan bill which calls for the Commodity Futures Trading Commission to have more control of the cryptomarket consisting of a variety of currencies, tokens, and coins. The measure designated digital assets as “ancillary assets” to be treated as commodities under the authority of the CFTC unless they behave like securities with privileges such as liquidation rights, dividends, or financial interest in the issuer. Digital assets are defined as natively electronic assets that confer economic or proprietary access rights or powers and include virtual currency and payment stablecoins. Virtual currencies are defined as digital assets that are used “primarily” as a medium of exchange, unit of account or a store of value; they are not backed by underlying financial assets. The bipartisan bill was introduced by Sens Kirsten Gillibrand, a Democrat from New York who sits on the Senate Agriculture Committee, and Cynthia Lummis, a first-term Republican from Wyoming who sits on the Banking Committee.
While it is up to Congress to decide how government agencies police US markets, the SEC and its chairman Gensler have for more than a year emphasized a need for the SEC to play a dominant role in the cryptomarket based on its interpretation of what constitutes a security. “The SEC believes that most digital assets fall under the category of securities,” says Richard Levin, who chairs the Fintech and Regulation practice at the law firm of Nelson, Mullins, Riley & Scarborough. “If digital assets are securities, Section 31 fees will apply and are meant to cover the costs incurred by the government, including the SEC, for supervising and regulating digital securities markets and professionals.” Digital assets, such as Bitcoin and Ethereum, are not securities and will be regulated by the CFTC or the US Treasury’s FinCEN as convertible virtual currencies, explains Levin.
Since taking office last year, SEC Chairman Gensler has repeatedly said the SEC has authority over all aspects of the cryptomarket, which he calls the Wild West. Gensler wants to expand the SEC’s Cryptounit to 50 enforcement agents from 30 agents, adding investigative staff attorneys, trial counsel and fraud analysts. The enlarged Cryptounit is expected to examine whether any token traded on a DeFi platform is a security. Gensle has also asked the SEC’s staff to work with digital asset trading platforms so they are regulated like securities exchanges.
Even if investors in cryptoassets were to pay the fees to ensure the SEC’s oversight of the market, there is no mechanism to implement and collect any fees. “Unlike in the equities market, there are no registered exchanges, self-regulatory organizations, or broker-dealers which can transact in cryptoassets,” says Alan Konevsky, executive vice president and chief legal and corporate affairs officer of t-Zero in New York. T-Zero owns an SEC- regulated trading platform for digitally-enhanced securities. Broker-dealers have rejected an SEC proposal that they be allowed to safekeep cryptoassets which are securities as long as they house them in separate dedicated units. The SEC has approved of the Boston Security Token Exchange as the first national exchange to use elements of blockchain technology, but it is a securities exchange and not a cryptoasset exchange.
Konevsky is cautious about whether Congress will pass the new bipartisan legislation given the pending midterm elections, the unfolding adverse developments in the cryptomarkets, and other national priorities. The bill also recommends that the CFTC, SEC, and cryptoindustry create a self-regulatory agency akin to the Financial Industry Regulatory Authority, the broker-dealer watchdog. A separate executive order signed by March by US President Joe Biden calls for federal agencies to review the risks of the cryptomarket and create rules to reduce them for investors. “Even if this or the next Congress were to enact some version of the proposed legislation, it would have to be negotiated extensively with the Biden Administration to overcome the President’s veto, particularly if President Biden doesn’t think the legislation provides enough protection for investors,” says Konevsky.
So far, it does not appear that the cryptoindustry will be paying for its oversight any time soon. However, STA’s call for it to do so will at the very least is an interesting argument that should be addressed by regulators, Congress and the cryptoindustry. STA, says Toes, recognizes that the cryptoindustry does not have in place the infrastructure needed to collect a transaction fee that could fund its regulation. However, as the cryptomarket grows such an infrastructure will become critical. Since regulators are now setting up rules and carving out jurisdictions for the cryptomarket it is an apropos time to put in place mechanisms to allow for funding. “When you’re building a bridge, that’s the time to plan for the toll booth. not after the bridge is completed,” says Toes.